ASC 606 Implications for Warranties
Consumers often weigh the pros and cons of purchasing product warranties. For the consumer, purchasing a warranty means that for an agreed upon period of time, the seller will repair the product (i.e. a new laptop or TV) if it stops working for a reason covered by the warranty.
For the seller, a warranty creates an added obligation to either repair or replace items. Warranties are paid for upfront and apply to a post-purchase period of 1, 3, or 5 years. Some sellers have terms in which customers can apply the value of unused warranties to a new purchase while others can recognize revenue once the warranty expires.
Types of Warranties
Assurance warranties provide confirmation for the customer that the product they've purchased will function as specified. That's the extent of assurance warranties - there are no other obligations of performance.
Service warranties, on the other hand, are separate performance obligations because the seller is providing distinct services beyond ensuring that the product will function as specified. While service warranties can be priced separately, that's not required for it to be considered a separate performance obligation.
ASC 606 and Warranties
Per ASC 606 guidance, companies must apply the 5 steps of revenue recognition to first determine whether the warranty is considered a separate performance obligation. The next step is to allocate the transaction price to both the product and extended warranty to recognize revenue evenly over the periods the warranty covers.
For example, if an extended warranty is for 3 years or 36 months, a portion of the allocated transaction price is divided by 36 and recognized each month for 36 months until the warranty expires.
Example: Basic Price Allocation
Suppose a customer purchases a television for $3,000 which includes a 3-year warranty. Other companies sell similar televisions with a one-year standard warranty as required by law. The standalone price of the television is $2,500 and $500 for the 2-year extended warranty. The company expects to incur $100 in expense for the assurance-type warranty period and provide warranty service evenly over the life of the extended warranty.
The first year of the warranty is an assurance-type warranty while the last 2 years are a service-type warranty considering the additional, separate service obligation required of the seller. The seller will allocate the $500 standalone price of the service-type warranty evenly over the 24 months of the extended warranty period.
The following journal entry would be recorded for the sale of the television, warranty expense, and extended warranty liability:
|Cash (or Accounts Receivable)||$3,000|
|Accrued Warranty Liability||$100|
|Unearned Revenue - Warranty||$500|
If the company incurs more warranty expense in the first year beyond historical trends, additional expense will be added. The company may subsequently conduct profitability analysis on the warranty claims to determine if price adjustments are necessary to avoid incurring losses to repair and/or replace products.
Each month for 36 months, the company will record 1/36th of the warranty revenue by reclassing $13.89 ($500/36) from unearned revenue.
|Unearned Revenue - Warranty||$14|
|Revenue - Warranty||$14|
The key to proper revenue recognition for warranties is to first determine if the warranty provides a service to the customer beyond the required agreed-upon specifications. Next, the seller or company must allocate the price to both the product and separate warranty obligation based on standalone prices. ASC 606 specifies the steps to follow (page 23 FASB ASC 606-10-55-30 through 55-35) to classify warranties as either assurance or service-type warranties. Following the new revenue recognition guidance ensures that companies properly recognize and account for warranty revenue, expenses, and associated obligations.